Market Structure (cont.

)
• Economists describe different types of
markets by:
(1) the number of firms
(2) whether the products of different firms are
identical or different
(3) how easy it is for new firms to enter the
market.

1
 Market Structure
• A market is a set of sellers and buyers whose
behaviour affects the price at which a good is sold.
• In this section we will see that the type of market a
firm operates in has a large impact on the firm's
behaviour.
• Firms have no control over price under perfect
competition, but they have tremendous control over
price in a monopoly setting.

2
 Market Structure (cont.)
• The four major types of markets can be
viewed on a continuum.

Perfect competition is at one extreme with

many small firms selling identical products.
3
 Market Structure (cont.)
• Monopoly is at the other extreme with just
one firm
• The intermediate cases are monopolistic
competition (which involves many small
sellers producing slightly differentiated
products) and oligopoly (which involves a
small number of large firms).

4
 Market Structure (cont.)
• Most developed countries firms operate
under monopolistic competition (e.g., novels,
movies, clothing, etc.) or oligopoly (tennis
balls, crude oil, automobiles, etc.).
• There are three conditions required for
perfect competition.

5
 Market Structure (cont.)
• (1) Numerous small firms and customers.
• Perfect information on price exists.
• (2) Homogeneity of product -The products
offered by sellers are identical.
• If the product is homogeneous, consumers
don't care from which firm they buy

6
 Market Structure (cont.)
• (3) Freedom of entry and exit. - no barriers to
enter the industry.
• so new firms can compete with old ones
relatively easily.
• They do not have to match the advertising of
the existing firms to secure customers.
• no large fixed costs that require large
investments in equipment before production
can start.
7
 Market Structure (cont.)
• Transaction costs are low
• Trans. Costs are – finding a trading partner,
negotiating a trade, enforcing the trade
• If these 4 assumption are met, then each firm
in the market will face a perfectly elastic
demand curve

8
 Market Structure (cont.)
• These 3 conditions are infrequently met, so perfect
competition is pretty rare in the developed countries.
• If this market structure is so rare, then why are we
bothering to study it?
1). There are some markets that meet these
assumption
e.g. i) stock exchange shares – million buyers and
shares are identical. – easy to enter& exit

9
 Market Structure (cont.)
ii) Many agricultural & relating industries -
Fishing
iii) P C is the standard by which all other markets
are judged.
iv) P C often provides a reasonable
approximation of what happens in markets
that are less than P C

10
 Market Structure (cont.)
• Market work more efficiently under PC
• PC ensures that economy produces what
consumers want using society’s scarce
resources mostly effective
• Profit Maximizing PC, = TR – TC, but TR = P.Q.
And TC is some function of q
 = Pq – TC(q) price
• We can write profit as (q)
is a function of Q,

11
 Market Structure (cont.)
• So (q) = P(Q).q – TC(q), is solely
 a
function of quantity.
• There is a subtle difference btn Q & q.
• Q – is used to refer to the market quantity and q - is
used when referring to a specific firm quantity
• in PC firms are price takers, therefore regardless to
how many units it sells the firm’s TR(q) = p(q)
• where P = constant at the level of firms demand

12
 Market Structure (cont.)
• Deriving MR curve
• We know that MR = ∆TR/∆q,
• Usually ∆qb = 1, sometimes we deal with
larger changes in quantity.
• for PC firm, MR = P
• rule for finding Profit maximising level of
output

13
 Market Structure (cont.)
• if MR > MC, can be raised by increasing
quantity of the output
• if MR < MC, can be raised by decreasing the
quantity of output
• the highest point of output is obtained where
MR = MC, since under PC, MR = P
• The highest is attained at the output where
P = MC

14
 Market Structure (cont.)
• = TR – TC = P.Q – ATC.Q = (P – ATC).Q
• (P – ATC) is the profit per unit of output. So
multiply this to Q to get profit
• The firm makes profit if P > ATC, but if P < ATC,
the firm incurs loss.

15
 Market Structure (cont.)
Rules for shutdown
• The shut down decision involves the
comparison btn SR fixed cost & VC
• The firm must pay its FC whether it stays open
or shutdown.
• If the firm shuts down TR = 0 & VC = 0, but FC
(or sunk costs) remains.

16
 Market Structure (cont.)
 Rule 1: If TR > TC, then the firm earns positive profits,
so it should remain open in both the short run and
the long run.
 Rule 2: If TR < TC (the firm is making losses),
but also TR > VC (the firm is making enough
revenue to cover its variable costs), then the
firm should stay open in the short run, but
should plan to shut down in the long run.

17
 Market Structure (cont.)
 Rule 3: If TR < TC (the firm is making losses)
and also TR < VC (the firm is not making
enough revenue to cover its variable costs),
then the firm should shut down immediately.
• If the reasoning behind Rules 2 and 3 is not
obvious, here is a proof:
• Loss if the firm stays in business = TC – TR

18
 Market Structure (cont.)
• Loss if the firm shuts down = FC = TC – VC
• So the firm should stay open in the short run if
TC - TR < TC – VC or TR > VC.
• Market supply represents the choices of all
firms in a market.
• The LR market equilibrium may differ from the
SR market equilibrium because the number of
firms may change

19
 Market Structure (cont.)
• If SR profits are > 0, new firms are lured into
the industry, forcing the market price down.

20
 Market Structure (cont.)
• PC leads to great efficiency for two reasons.
• 1) P = MC, i.e. customers keep buying more of
the product as long as the sh. value of
consuming the good is greater than the
additional cost of producing it

21
 Market Structure (cont.)
• 2) in the LR competitive firms must produce
where P = the lowest point on their ATC curve.
• i.e. the product is produced at the lowest
possible cost per unit

22
 Monopoly
• A monopolist is defined as a single seller of a
well-defined product for which there are no
close substitutes.
• In reality there are very few “true”
monopolist.
• People often consider firms with a large
market share (such as Microsoft) as
monopolistic.

23
 Monopoly (Cont.)
Causes of Monopoly
1) Government-created monopolies: - are
established if the government prevents other
firms from entering the industry.
2) Natural monopoly - large scale production
makes easy for a firm to supply the entire
demand.
3) Control of a scarce resource or input- eg
DeBeers
24
 Monopoly (Cont.)
• In the PC market, the market demand curve is
downward sloping, and the firm’s demand
curve is horizontal (perfectly elastic).
• In a monopoly, the market demand curve is
also downward-sloping
• Since there is only a single seller in the
market, the market demand curve is also the
monopolist’s demand curve

25
 Monopoly (Cont.)
• A monopoly does not have a supply curve
• The monopoly has a say on price
• It has the power to select the point on the market
demand curve that maximize its profit.
• The increase in price will not cause the monopoly to
loose all its customers but ↑in P ↓ the quantity
demanded.

26
 Monopoly (Cont.)
• Profit Maximization in Monopoly
• The monopolist compare MR = MC just like in
PC.
• The difference is that we can no longer
assume MR = P
• MR is always below the demand curve if the
demand is down sloping, so MR < P

27
 Monopoly (Cont.)
• That’s why the Monopoly charges the same
price to all of its customers.
• If the firm wants to ↑ sales, it must ↓ P to all
customers including those who are ready at
high price.

28
 Monopoly (Cont.)
Deriving a MR function
• We will only work with linear inverse demand
functions. At the end of the derivation, I will give you
a rule that you can use to find the monopolist’s MR
function for any linear inverse demand function.
• Recall that T R = P (Q). Q which = (a - bQ) . Q for a
general linear inverse demand function with
intercept “a” and slope (-b).

29
 Monopoly (Cont.)
• We want to see how total revenue changes for
a very small, essentially zero, change in
quantity.
• Start with the total revenue of some quantity
Q.
• T R (Q) = (a - bQ) * Q = aQ - bQ2
• Now, find the total revenue for Q + h, which h is
some positive, albeit very Small, amount.

30
 Monopoly (Cont.)
• T R (Q + h) = (a – b*(Q + h)) * (Q + h) = (a - bQ
- bh)*(Q + h)
• = aQ - bQ2 - bQh + ah - bQh - bh2
• So, T R (Q) = aQ - bQ2 and T R (Q + h) = aQ -
bQ2 - 2bQh + ah - bh2
• (notice that I combined the 2 (-bQh) terms
into (-2bQh)).

31
 Monopoly (Cont.)
• The definition for MR says that it is the change
in T R divided by the change in quantity.
• The change in T R is:
• ∆T R = (aQ - bQ2 - 2bQh + ah - bh2)- (aQ - bQ2)
• This simplifies to:
• ∆T R = (-2bQh + ah - bh2)

32
 Monopoly (Cont.)
• Since we began by producing Q and we have
now increased production to Q + h, the change
in quantity is Q + h - Q = h. So our MR is:
TR (2bQh  ah  bh 2 )
MR(Q)  
Q h
Simplifying, we are left with
MR (Q) = (-2bQ + a - bh)

33
 Monopoly (Cont.)
• There is one final step. Recall that we wanted
h to be a very small number,
• essentially zero.
• If h is essentially zero, then the term (-bh) = (-
b*0) = 0
• and it drops out. This leaves us with (I will
rearrange so that the “a” term is first):
• MR (Q) = a - 2bQ
34
 Monopoly (Cont.)
• In other words, the MR function is simply the
derivative of the T R function with respect to
quantity. So:
dTR(Q) d (aQ  bQ 2 )
  a  2bQ
dQ dQ

• Either way gets you the same answer, that the MR

function is a - 2bQ for a linear inverse demand
function of the form a - bQ. This is our rule:

35
 Monopoly (Cont.)
• RULE: If the inverse demand function is a
linear inverse demand function of the form P
(Q) = a - bQ, then the marginal revenue
function is: MR (Q) = a - 2bQ.
• Profit maximization
• Assume that the inverse demand function is: P
(Q) = 24 - Q.
• This means that the MR function is: MR (Q) = 24 -
2Q.
36
 Monopoly (Cont.)
• seting MR (Q) = MC (Q). It gives us:
• 24 - 2Q = 2Q
• 24 = 4Q
• Q=6
• Since P (Q) = 24 - Q.
• P (6) = 24 - 6 = 18
• The firm will sell 6 units at a price of 18.

37
 Monopoly (Cont.)
• TR = $ 18* 6 = 108
• Now, find the ATC that corresponds to the
profit-maximizing quantity.
• We can use the ATC function, which is
12
ATC (Q)  Q  .
Q
• ATC(6) = 6 + 12/6 = 6+2 = 8
• Therefore, the ATC for producing 6 units is $ 8

38
 Monopoly (Cont.)
• The monopolist TC is ATC*Q = 8*6 = 48
• Profit = TR – TC = 108 – 48 = $ 60

39
 Monopolist PE of demand

• We can determine how powerful is the

monopolist in the market if we calculate the
monopolist’s PED.
• We know that for a linear inverse demand
function, MR (Q) = a - 2bQ. Use the following
steps to rewrite the MR.
• MR (Q) = a - 2bQ = a - bQ - bQ
• We know that P (Q) = a - bQ, so:

40
 Monopolist PE of demand
• MR (Q) = P - bQ
P P
• We also know that ( b ) 
Q
, ( where
Q
is negative)

• Then, MR(Q)  P  P Q
Q

• Multiply both sides by “one”. On the left-hand

side, we will choose our “one” to be 1, and on
the right-hand side we will choose our “one”
to be P/P
41
 Monopolist PE of demand
p P
MR(Q)  (P  Q)
p Q

• Distribute, P  P  P
MR(Q)  P   * Q
P  P  Q

P Q
• Now rewrite as MR(Q)  P  P *
Q P

• Factor out p  P Q 
MR(Q)  P 
1  * 
 Q P 

42
 Monopolist PE of demand
• Recall that price elasticity of demand is equal to
 P Q 

 * 
 Q P 

• Notice that the last term is just a reciprocal of the
PED  1 
MR(Q)  P 1  
 PED 

• Where P ED is negative (and NOT the absolute value)

• This formula has some interesting implications for
the monopolist’s pricing decision Why?

43
 Monopolist PE of demand
• First, notice that
• if P ED = -1 then MR = 0.
• If 0 > PED > -1, then MR < 0.
• If -1 > PED > , then MR > 0.
• This suggests that the monopolist will
never price on the inelastic portion of its
demand curve, as the

44
 Monopolist PE of demand
• monopolist will actually be losing revenue by
choosing a price on the inelastic portion of the
demand curve.
• Recall that the elasticity for a linear demand
curve depends on the particular
point chosen along the demand curve.
• As we move up the demand curve (higher
prices), demand becomes more elastic.
45
 Monopolist PE of demand
As we move down the demand curve
(towards a 0 price), demand becomes more
elastic.
• For linear demand curves, the quantity level
halfway between 0 and the point where the
demand curve crosses the quantity axis is the
point that corresponds to P ED = -1. Thus, the
MR at this point is zero.

46
Price-cost Markup and Market Power(cont)

• In PC, MR = MC but firms MR = P

then P = MC
• In monopoly, price charged is above the MC
• Therefore, the price – markup formula is

P C
• The formula will range from 0 to 1:
C

47
Price-cost Markup and Market Power(cont)

• If P = MC, the price-cost markup will equal 0;

• as the monopolist increases its P above MC
(making MC very small relative to price), then
the price-cost markup will tend to 1.
• So, the closer the number is to 0 the less
market power the firm has.

48
 Lenner Index & Market Power

• Alternative method of determining market

power is to look at the lenner index.
• Recall that MR  P 1  1 
 PED 

• At profit maximizing quantity, MR = MC, so

 1 
P 1    MC
 PED 

49
 Lenner Index & Market
Power(cont)
• At the profit – maximizing quantity
 1  then,  1  MC
P 1    MC 1   
 PED   PED  P
• Multiplying both sides by -1 we get
1 MC
1  
PED P
• Add 1 to both sides by, left by 1 and right side
add term p/p we get,
50
 Lenner Index & Market
Power(cont)
1 p MC
1 1   
PED p P

• Simplify to get, 1 P  MC
 
PED P
• Interpretation?
• At profit – maximizing quantity, the price –
cost markup is simply the reciprocal of the
monopolist PED at the quantity.
51
 Lenner Index & Market
Power(cont)
• Note.
• The more elastic demand is at profit
maximizing quantity, the less market power
the firm has.
• Homework. Go and read on
• Monopoly and Social welfare

52
 Monopoly & price discrimination
• Price discrimination
• Is said to exist if a producer is selling the same
good at different prices for reason not
associated with differences in cost.
• E.g. prod.cost, transport costs
• price

53
 monopoly – Price Discrim.(cont)
Types of price discrimination
1) Perfect P discrimination or first degree order
of P discr.
a) Involves charging a different price for each
unit of output.
b) It involves charging different prices to
different customers

54
 monopoly – Price Discrim.(cont)
c) Charging different prices for different units
sold to the same consumers.
- The maximum price that someone is willing to
pay for a unit of output is called the
reservation price.
- Perfect price discrimination is rather difficulty
to implement in practice

55
 monopoly – Price Discrim.(cont)
• Can only be used for services for which no
resale is possible & negotiation with each
customer is costly.
2) Second degree price discrim.
- Occurs when the monopolist is able to charge
several different prices for different ranges or
group of output
e.g. electricity bills, gas etc.

56
 monopoly – Price Discrim.(cont)
3) Third- degree price discrim.
- It occurs when a monopolist partition market
demand into two or more group of customers
& then charge different prices to the group
- The price is uniform within a group.
- Always the monopolist tries to exploit the
difference of PED for different group.

57
 monopoly – Price Discrim.(cont)
• Monopolist allocate her output to the two
markets so that MR1= MR2
• As the monopolist increase Q, TR can increase
or decrease.
• This depends on whether the MR is negative
or positive which also depends on whether
demand is price elastic or inelastic. Why?

58
 monopoly – Price Discrim.(cont)
• MR = P[1-1/n]
• This always occur when curve is down sloping.
• Since P = AR we can state that
MR = AR[1 – 1/n)
• Since we established n as a positive number,
then

59
 monopoly – Price Discrim.(cont)
1) – 1/n, and so MR< AR
2) As n keep decreasing, 1/n keep increasing &
MR keep decreasing
3) If n > 1, [1 – 1/n] is positive hence MR >0,
Or TR increases as Q increases
4) If n<1, [1 – 1/n] is negative, hence MR <0,
Or TR increases as Q increases.

60
 monopoly – Price Discrim.(cont)
5) if n = 1, [1 – 1/n] = 0 and MR = 0, then TR is
constant.
• If n = ∞, {1-1/n} = 1 and so MR = AR
• Since MR1 = MR2
• P1(1-1/n1) = p2(1-1/n2)
• If R1 < R2, then 1/n1 > 1/n2 and
• (1-1n1) < (1-1/n2)
• Then P1 must exceed P2

61
 monopoly – Price Discrim.(cont)
• i.e. discriminating monopoly charges a high
price to group with less elastic demand
• If n1 = n2, price maximizing price is the same
there is no need of Price discrimination.

62
 monopoly – Price Discrim.(cont)
• Excersise.
• The demand function in the two market are.
P1 = 50 – q1, P2 = 25 – q2/2,
• MC = AC is constant and = 10
• Required
1. Find q1 and q2
2. Total profit for monopoly

63
 monopoly – Price Discrim.(cont)
• Monopolist profit maximizes profit by
equating MR & MC
• Therefore, MR1 =MR2 = MC
MR1 = MC gives
50 – 2q1 = 10
Or
q1 = 20, p1 = 30

64
 monopoly – Price Discrim.(cont)
MR2 = MC gives,
25 – q2 = 10
Or
q2 = 15, p2 = 17.5
• the monopolist produces a total output of 35
and charges prices of 30 in market 1, and 17.5
in market 2.

65
 monopoly – Price Discrim.(cont)
• The total profit for monopoly is
P1q1 + P2q2 – c
30(20) + (17.5)(15) – (10)(35) = 512.5
• If a monopolist charges a single price what
will happen?
• To find a demand we have to write a demand
function as;

66
 monopoly – Price Discrim.(cont)
q1 = 50 – P
q2 = 50 – 2p
total demand is Q = 100 – 3p
or
P = 100/3 – q/3 (as long as P < 25
• now, MR = 100/3 – 2q/3 & P = 65/3
• the monopolist profit are

67
 monopoly – Price Discrim.(cont)
(65/3) 35 – (10) 35 = 408.33
• Interpretation, the total output is an affected,
but profits are higher by 104.12 under price
discrimination

68